Distribution remains a challenge for Canadian oil producers

Christian Charest: For Morningstar, I'm Christian Charest. Energy producers operating in Canada's oil sands are highly dependent on a solid transportation infrastructure in order to operate to their full potential. And recently, this has been a challenge. To talk about what this means for investors, I'm joined from Chicago by Morningstar equity analyst, Joe Gemino.

Joe, thanks for being with us.

Joe Gemino: Thanks for having me.

Charest: The output from Canadian oil producers continues to grow but the ongoing challenge seems to be getting that crude to the refineries.

Gemino: Right. We expect Canadian crude supply to average 4.8 million barrels a day this year, and we expect that to grow to almost 5.1 million barrels a day in 2019. The issue is, Canada has limited refining and pipeline outlets and we expect a surplus of 400,000 barrels a day this year and that surplus to grow to 550,000 barrels a day next year. As a result, we have seen Canada's heavy oil discount widen this year. So far this quarter it's averaged US$25 a barrel and it's currently hovering around US$30 a barrel and that compares to last year's average of US$13 a barrel.

Charest: And what's the outlook in the near term as far as getting Canadian crude to these outlets?

Gemino: Well, we do expect some relief in 2019. We expect producers to enter into contracts with rail operators which should ease the heavy oil discount to potentially around US$20 a barrel. Right now, we see some issues as the rail operators are hesitant to commit some of the resources to producers without long-term take-or-pay contracts. But once these issues are sorted out, we do see some relief next year. But really, the true relief won't come until pipeline expansion projects are placed into service.

Charest: Pipelines have been a contentious issue on both sides of the border, but there has been some movement lately on that front. Can you give us an overview of what's been happening as far as pipelines?

Gemino: We have seen some positive movement recently. We've seen Minnesota approve Enbridge's Line 3 expansion project in June of this year. This project will add about 370,000 barrels a day of incremental pipeline capacity to the U.S. and we expect this project to come into service in the beginning of 2020 which is slightly behind Enbridge's estimate of the end of 2019.

We've also seen some positive movement with TransCanada's Keystone XL, which was approved by Nebraska in November of 2017. This 830,000-barrel-a-day project should come into service at the end of 2021, which is also slightly behind TransCanada's timeline. And finally, we've seen the Trans Mountain Expansion Project look a little more cloudy. The pipeline expansion was sold to the Canadian government by Kinder Morgan earlier this year and they have had some trouble getting the project up and running. So, Kinder Morgan originally expected this project to come into service at the end of 2020, but it looks like this project could be delayed for at least a year.

Charest: Let's talk about some of your picks in the Canadian energy sector. One stock that's been a favourite for some time now is Enbridge.

Gemino: Enbridge Energy is both a best idea and has a wide moat rating and is our best bet in the Canadian energy sector. We see tremendous upside in the stock. It has an attractive dividend yield of 5.8% and supports one of the best moats among the midstream sector. That's why we see this stock as a triple threat. We think the company will easily meet its 10% annual dividend growth target throughout 2020 while maintaining a comfortable 1.4 times coverage ratio.

Charest: Another favourite is Cenovus which right now is trading at a significant to your estimate of its fair value.

Gemino: That's right. Cenovus Energy is one of our best ideas and our best bet among the oil sands producers. We think the market has been a little too narrowly focused on its temporary increase in leverage and has overlooked its growth potential from its oil sands reserves that can be brought online with its industry-leading solvent-assisted technology. Once some of these new pipelines are placed into service, we see Cenovus undertaking these growth projects which will really increase the cash flows for the company.

Charest: And among the pipeline companies you see some upside in TransCanada.

Gemino: We see 25% upside in TransCanada. It's rated with 4 stars and a narrow moat. And we think right now the market is paying too much attention to some of these outside factors such as the FERC regulations, rising interest rates and the widening of the heavy oil discount and is overlooking the company's growth portfolio which we think will add incremental cash flow and support the company's dividend growth which it expects to average 8% to 10% throughout 2021.

Charest: Joe, thanks for sharing your insights with us today.

Gemino: You're welcome. It was great chatting with you.

Charest: For Morningstar, I'm Christian Charest. Thank you for watching.